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What is Credit Utilization?

Credit utilization is one of the most important components of your credit score, a three digit number that is increasingly becoming one of the most important numbers in your life. Credit utilization refers to how much you are using your available credit. Take your total credit balances, divide it by your total credit limit, and the percentage is known as your credit utilization.

Simple right? So why is it so important?

This post is part of the Bargaineering Annual Financial Review [3] week series where we take a closer look at the four major facets of personal finance and see if we can do better. This post is part of day two – reviewing and optimizing your relationship with credit.

Why Credit Utilization is Important

Fair Isaac Corporation, the creator of the FICO credit score, broadly defines their equation as having five pieces: payment history (35%), amounts owed (30%), length of credit history (15%), new credit (10%), and types of credit used (10%). Credit utilization is just the fancy pants name of a component of that “amounts owed” category that accounts for 30% of your score.

Logically, this makes sense though. Put yourself in the creditor’s shoes, who is riskier: a person with a high credit utilization or a person with a low credit utilization? Obviously the person with a higher utilization because they are “close to the brink.” The person with a lower utilization will have a better credit score.

How does this affect you?

This is important because in our current economic climate, with impending credit card legislation, credit card companies are looking to cut down on their risk. People like you and me might be thinking about cutting down on our risk as well, chopping up a few credit cards in the process. Credit utilization affects you because when you cancel a card, or when a company cancels it on you, your credit utilization will go up – you will look riskier even though nothing changed.

There are ways you can minimize the impact of canceling a credit card [4], things you should do now if a company hasn’t given you the axe, but in the end your utilization will still be affected.

Finally, if you pay off your balances each month, utilization still affects you. Credit card companies report statement balances each month as the current balance on the card. You can pay it off but the balance is still reported and your utilization is calculated based on that number, even if you’ll be paying it down to $0 the next day.

I hope that partly demystifies some of the advice out there about canceling credit cards and how it affects your credit score. If I was unclear or missed an important point, please leave a comment so we can get this right. Thanks!

(Photo: andresrueda [5])